When they do, often shortly before entering or at the point of retirement, they are shocked by the levels of assets required to generate sustainable real income – that is, income for life, after inflation.

For people entering retirement in industrialized countries there are three potential sources of income: state-sponsored retirement schemes; occupational retirement schemes for those lucky enough to work for an employer providing a pension (or to be a member of professional or union scheme); and/or income from personal wealth holdings, including after-tax or tax-protected defined-contribution portfolios.

A fourth source of “retirement” income is work. This may seem a paradox, but many people choose – or are forced – to work in retirement. However, this form of income is not generated from financial capital; rather it comes from human capital.

Except for government pay-as-you-go (PAYG) systems, all three principal sources of financial income require accumulated assets be converted to income. The assets-to-income conversion in state and occupational schemes is done institutionally by professional actuaries and portfolio managers. Yet, individuals assume the responsibility and risk of how and when to convert their private assets to income. At this point, confronted by this task, many begin to realize the true cost of retirement. It is often the time when private investors realize how much their actual accumulated portfolio may differ from the “long-term” averages often assumed in investment strategies (PROJECT M September 2009, Hope is not a retirement strategy).

How does one connect spending desires in retirement to sustainable income; and then connect retirement income to financial assets that retain their value in a volatile and uncertain world? A straightforward step is for individuals to identify the key retirement-income variables and connect them in one framework.

As an example, the data in Figure 1 depicts the sources of retirement income for an individual in the United States: private, occupational and state financial capital.

It is in the layer of private financial assets that the individual makes the decisions to convert assets to income. This layer is organized into three groups: growth, liquidity and base-guaranteed. Using current or forecasted market rates for each asset class, the assets-to-income calculation can be made. 

Typically, the base-guaranteed group is an annuity or similar guaranteed payment. The liquidity group provides certainty of payment, yet allows for liquidity. For example, a portfolio carefully structured to hold TIPS and pay out a constant income stream for 20 to 30 years until depletion. If necessary, the remaining unpaid-out balance of the TIPS portfolio can be sold at any time.

The assets in the growth group are return-generating and are not guaranteed. These assets are put at risk, in expectation of earning a return or risk premium. The growth group also provides income, depending on market conditions and the individual’s asset allocation decisions.

Decision variables are made explicit within this framing. How much income will come from non-portfolio sources? What are the market rates that will convert assets to income? Given the assets and asset allocation, how much income will those assets generate? Also explicit are the variables an investor has no control over. This is especially true for future interest rates and inflation rates.

Separate layers allow “guaranteed” income to be compared to “at risk” income and make clear which assets and income have liquidity risk, market risk and inflation risk. As retirement nears, the view helps individuals choose the points in time to convert assets to income.

This is valuable since market conditions are time-varying, yet a person is generally working towards one – and only one – ideal retirement date. A layered approach creates a focus on income expectations in retirement and then works backwards using specific and explicit market assumptions.

Controllable decision variables can be adjusted, especially how much is to be saved and how much risk is to be carried in portfolios. Shortfalls, or expected shortfalls, can be seen and measured. With this information, individuals can adjust their portfolios, their consumption or how much longer they need to work.

Lifetime saving and consumption decisions are extraordinarily complex, and almost every variable is uncertain. However, where it is possible to decrease uncertainty, we should organize to do so. Assets-to-income planning offers investors one way to reduce financial uncertainty.

It is often reported that people do not save enough money and that financial literacy is overall quite poor. As an industry, we need to support individuals in their decisions relating to asset accumulation and decumulation for retirement with helpful tools like assets-to-income planning. The result will be individual investors who are better prepared to enter retirement – a retirement that they can enter without experiencing a sudden financial shock.

Published by PROJECT M in September 2009